I wonder what M. Damodaran’s colleagues thought of his idea of mandatory IPO ratings. The Sebi chief hosted several of his contemporaries from across the world at the International Organization of Securities Commissions conference in Mumbai two weeks ago; his idea would have made for a very interesting discussion.
Meanwhile, I have some questions. First, do mandatory ratings fit in with the objectives of securities regulation? Second, does it make sense to take an informational input, a rating, and make it a regulatory requirement? If indeed—and that’s a big if—the idea makes sense, should it be done by credit rating agencies?
There are three overarching and closely interlinked objectives to securities regulation: investor protection, ensuring that markets are fair, efficient and transparent, and the reduction of systemic risk. While there is considerable overlap in these objectives, there are subtle distinctions in the way they are realized. Does an IPO rating help meet these objectives?
No great insight is required to conclude that investors have to be protected from being misled or manipulated. The best protection is accurate and credible information that will allow investors to assess risks, and solid standards for disclosure for issuers, issue managers and other market participants. This is already known to be well covered by current regulations.
True, by their very nature, securities markets are fertile ground for sophisticated frauds such as the “vanishing companies” that Damodaran cites. Which is why securities regulators have comprehensive investigative, surveillance and enforcement powers, from the imposition of steep penalties through delisting securities to criminal prosecution. A rating requirement is a poor substitute for the use of those powers.
Fair, efficient and transparent markets are inextricably wound up with investor protection. That requires a robust framework—strong, enforceable laws, rules, regulations and procedures and higher disclosure standards. But, most importantly, Sebi must use its powers with investment and merchant banks, and other market participants involved in IPOs, to dissuade potential fraud. The perception of its power is as important as its reality.
The risk of systemic failure in the IPO market is relatively low, though it may affect some investment banking firms. Isolating the fallout of such a failure from the broader market is a concern for the regulator; but there is little in recent history to suggest that IPOs can trigger a market crisis of systemic proportions.
How will an IPO rating work? Since credit rating agencies are going to do it, their current methods may be a guide. Rating agencies measure the risks associated with the ability of a borrower to repay debt obligations; risk assessments are based on past financial history and business performance. Which brings us to the sixty-four thousand-rupee question: Should investors substitute the regulator’s judgement on risk for their own?
Credit risk is factored into price, as reflected in the interest rates that investors will demand based on the credit rating. (It is interesting that Sebi is considering regulation of price bands for IPOs at the same time that it is thinking of an IPO rating.) Besides, if one can rate an IPO, the logic should extend to secondary markets, too. Perhaps Sebi thinks investors need help there, too?
A number of entrepreneurs are chasing the next big idea that will need investors and investment capital—many of them might consider the IPO market. In a market that requires rating, a lack of history is a liability, even if the idea itself turns out to be a good business proposition. Even for ideas whose potential is recognized, I imagine shopping for “good” ratings can become part of business practice. And let’s not even think about the opportunities for negotiating IPO ratings, and the potential for graft.
While it is not a responsibility, facilitating capital formation and thus economic growth is an important role for the securities market regulator. Underlying the objectives of regulation outlined above is the tacit assumption that regulation, which imposes an unjustified burden on the market and inhibits market growth and development, is inappropriate.
Here is a Pied Piper of Hamelin kind of story. Two years ago, ICICI Mutual Fund launched an exchange traded fund, or ETF. ETFs, being index funds, should trade at net asset value (NAV). For a few days, SPIcE was trading at over three times its NAV, ostensibly because investors confused it with Spice Telecom. Despite several public warnings that an ETF could not trade at a price well over its NAV, nobody was listening. Investors cannot be protected from their own greed.
It is mystifying that investors who display enormous care in shopping around for the best prices when they buy vegetables or pay their housemaids should be so wilfully ignorant about buying stocks. Damodaran’s concern for investors in touching, but it is misplaced. If fraud in the IPO market is out of control, perhaps investors should look at another place for the culprit: in the mirror. Investors don’t need protection, they need education. And if they have to pay a high price for it from time to time, so be it.
Srikanth P. Srinivas is a former journalist. Comments are welcome at firstname.lastname@example.org